The Financial Crisis Impact On Risk Management [Tom Day] Handouts


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The Financial Crisis Impact On Risk Management [Tom Day] Handouts

  1. 1. The Financial Crisis: Impacts on Risk Management and Key Lessons LearnedPresented by: Thomas DayVice-Chairman,Vice-Chairman PRMIA Board of Directors andManaging Director of Risk Solutions and Policy,SunGard
  2. 2. Standard Disclaimer• The views, expressions and ideas of this presentation are those of the author and do not necessarily reflect the views and opinions of SunGard or the Professional Risk Managers’ International Managers Association (PRMIA)• Thank you to PRMIA, the Federal Reserve System, SunGard and y y all the participants and organizers of this conference. It is noteworthy the duration and importance of this annual event at the Chicago Federal Reserve Bank. Sixteen years in a row…in November…couldn t November couldn’t we have figured out by now a better date is in July or August?• I am going to strive to be slightly thought provoking as we hop on- on board the regulatory reform tsunami.
  3. 3. Agenda• Now about that regulatory failure…• Some words on the Dodd-Frank Act (DFA)• The future of finance and, importantly, financial risk management?
  4. 4. Agenda• Now about that regulatory failure…• Some words on the Dodd-Frank Act (DFA)• The future of finance and, importantly, financial risk management?
  5. 5. Do you recognize this quote? This is “…the most important federal legislation relating to the financial community since the 1930s ” 1930s.1. “On March 31, 1980, President Carter signed into law the Depository Institutions Deregulation and Monetary Control Act of 1980 the most important federal legislation relating to the financial community 1980, since the 1930s. The act has nine titles covering a wide range of subjects, including reserve requirements, access to and pricing of Federal Reserve services, a phase-out of Regulation Q and new powers for thrift institutions.” – Frank Morris, Former President, FRB Boston2. “Last year the Financial Modernization Act of 1999 (FMA) was signed into law. Also known as the Gramm-Leach-Bliley Act, this statute represents the single most important set of regulatory reforms Gramm Leach Bliley since the Glass-Steagall Act of 1933.” - James Thompson, FRB Cleveland, 15-April-2000 …and here we are, once again, with the most important federal legislation since the 1930s: The Dodd Frank Act (DFA) Collectively Dodd-Frank (DFA). Collectively, it seems we have a rather short memory. History is important. More of us should study it.
  6. 6. What Really Happened?• According to the media and, to some degree, the DFA itself (and too many academics it seems): Answer #1:  The regulators failed to control the excesses of the now infamous “banksters”. Therefore, we need much more and better regulation. Thus, the Dodd-Frank Act’s (DFA) majesty will protect us from the next crisis because we’ve fundamentally addressed the problems that created the global financial crisis. DFA DFA Banksters? Asleep at the wheel?
  7. 7. We take this Commercial Break to Set the Record Straight: It wasn’t the regulatorsWithout the direct influence of We continue to possess a patchworkcongressional action(s), the of regulatory agencies, even if webreadth, depth, duration, and have vested one agency with morescope of the financial crisis could power than any other – the Fed.never have happened. This crisis While the number of supportingis a direct consequence of characters is vast, the fault restslegislative ineptitude and an almost eg s at e ept tude a d a a ost squarely with our legislators – whichcomplete absence of timely and means it rests with the Americanresponsible action by our people. What happens when thelegislature. sovereign becomes the greatest sources of systemic risk?
  8. 8. The Truth About Regulation• Charter shopping has been common for many years. One of the best storied examples may be Colonial Bank, which failed on August 14 2009 14, 2009.• Goal: Which regulator will be most useful for me, the “constituent”? “ tit t”? “Kerry Killinger, the CEO of Washington Mutual (WaMu) will be in town Friday and wants toregulators, in their “relationship” largest constituent asset wise.” o Some have a lunch meeting. He’s my management capacity, fancy themselves as consultant/advisors, not beat-cops. Very few risk-focused – May 2007, OTS internal e-mail exams that labor on the USC and CFR. TBTF or TCTM?• However: Weak regulation didn’t “cause” the problem. Moreover, adding more of what didn’t work won’t fix the structural issues that continue to exist. Thus, Answer #1 – regulators and banksters - is wrong. Contributors? Sure. Foremost to blame? Not a chance.
  9. 9. The Truth About Regulation• The regulators have had sufficient authority to clamp down on excesses for a long time. We all know this fact.• A strong approach didn’t happen for a large # of reasons: o Charter shopping and “functional regulation”: 1) Divide and conquer, a good war-plan. Fighting battles on many fronts war plan. has never had much success. 2) A Congress eager to appease and “tear down those walls” o “Ability” to supervise versus “Will” to supervise y p p 1) “The banks are always two steps ahead of us.” Why? This is fixable. However, in the years of enlightened regulation, it was assumed proper and fitting. o APA (P.L. 79-404) and the PRA (P.L. 96-511) 1) Good examples of how to institutionalize poor agility, flexibility and timeliness
  10. 10. IMF’s Lessons for us?Worth reviewing:1. Good supervision is intrusive2. Good supervision is skeptical but proactive3. Good supervision is comprehensive4. Good supervision is adaptive5. Good supervision is conclusiveTo achieve these elements you need adequate resources resources,clear strategy, robust internal organization, effective workingrelationship with other agencies (e.g., umbrella supervision)and the willingness to act. g
  11. 11. So, if not regulation, what then?Idea: Capitalism and markets have failed. We can “fine-tune” the economy.We have the right levers and knobs, we simply need to “fix” the inherentfailures of the market system. Put the right people in the cockpit and she willfly. LIFE LIBERTY and the (…)This is a fallacy. We haven’t had a “free” market system in a long-time. Ourcurrent GSE (i.e., Government Sponsored Economy) is a direct result of“covert collectivism”. In the United States you have the right to: y g …pursuit of a 5/1 IO mortgage at an affordable rate with little or no $ down. Ifthat doesn’t work, a Pick-a-Pay Option ARM with a 125% neg am cap will do.
  12. 12. So What Happened? ANS: A Systemic Failure Due to our “Home Ownership is a Right” National Policy Goals + “Fine-tuned” Monetary Policy “To those of you who have not yet reached Presidents Club, I want each and every one you to believe you have the potential to achieve this great reward. reward Now is the time to really kick it into high gear and drive for attending this awesome event! Rankings are updated and posted monthly... Im especially pleased with your ability to change with the market and responsibly sell more higher-margin p p y g g product - Option ARM, p Home Equity, Non-prime, and Alt-A.” - November 2006, WaMu Internal E-mail1. Can’t compete head-to-head with GSEs. A Risk Adjusted Returns (in funding curve we can t match. Improperly priced can’t Basis Points) credit derivatives & taxpayer funded dividends.2. Cheap credit: A “glut” of liquidity3. Incentive Plans: Focus on today’s GAAP earnings, not value creation value-creation ???4. Poor risk-controls: growth, concentrations, funding5. Lack of transparency6. New and untested product(s)
  13. 13. So What H S Wh t Happened? d? ANS: …. + Poor Monetary Policy • From October of 2001 through 10 Year less 3-Month CMT September of 2005, the average spread 43.535 between 10-year UST and 3-mo UST 10 year 3 mo was 262bp 32.5 • Coincident with the “removal” of this 2 spread via the curve flattening which1.5 began in ~ Summer 2004, the market for 1 “opacity” picked-up. Reminiscent of the0.5 1992-1994 structured note boom, but on 0 houses (whose values never decline!) Oct-00 Apr-01 Oct-01 Apr-02 Oct-02 Apr-03 Oct-03 Apr-04 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10-0.5 -1 • In the search for yield, opacity/complexity pays (or it did) 10 Year less 3-Month CMT o CDO, PLRMBS, CDS, CLO, SCDO, CDO^2, LCDS, CMBS, CCOs, etc.
  14. 14. …and poor corporate governance• Bonuses: 2006 = $60 billion Bonuses paid to the top 5 2007 = $66 billion financial fi fi i l firms i th U S A in the U.S. Are these “risk-adjusted” bonuses? 2008 = $72 billion 2009 = $90 billion• Compensation should be based on value-creation, not the ability to t manufacturer short-term, GAAP ( IFRS) earnings; however, f t h tt (or i h many compensation packages have been based solely on ROE. • The market should discipline rent-seekers. Equity is meant to be “owned” not merely t d d and certainly not manipulated. “ d” t l traded, d t i l t i l t d • Like getting married. Should feel the full weight of “I Do.”
  15. 15. Summary Point: Not a lack of Regulation• Misguided public policy in the form of directed credit and capital to the housing industry spurred on by an aggressive curve slope for an “extended period” extended period 1. USG writing mispriced credit derivatives on housing should come to an end. Dealing with housing policy should be the national priority, not simply the mortgage interest deduction as discussed in the 1-Dec-2010 National Commission on Fiscal Responsibility and Reform Report 2. USG writing of other guarantees should stop, or be accounted for via GAAP o Sidebar: Should USG finances be GAAP-based? According to shadow stats, debt using GAAP is ~$70.7 trillion in 2009, or approximately ~5x GDP• Poor incentive structures within firms and a “sell-side”, “HFT”, “make a quick buck” (i.e., “Noise”) mentality to equity ownership. This institutional arrangement fosters rationally unsavory capital allocation decisions in the pursuit of EPS. it f EPS • It raises profound questions about the corporate structure itself, and especially corporate governance.
  16. 16. Agenda• Now about that regulatory failure…• Some words on the Dodd-Frank Act (DFA)• The future of finance and, importantly, financial risk management?
  17. 17. Regulatory Reform:Timeline to the Current State
  18. 18. Broad Principles: Robustness, Transparency, Resilience • FSOC • CCPs • Countercyclical capital • Resolution Authority • CFTC (from 14 to 20) • Contingent capital • Office of Fin’l Research • FMUs • FDIC assessments • Volker Rule • Improved disclosures • Basel-3 • Routine stress-testing • OFR  quality & quantity of • Non-bank Fis • CFPB capital • Growth restrictions • FIO ( US Solvency 2 ) (“US 2”)  liquidity standards • Redefine capital Robust Transparent Resilient International Harmonization and Coordination(…) ESRB FSB G-20 FSB BCBS IOSCO (…)
  19. 19. Does the DFA help?• The premise of the DFA is that the “problem” was weak regulation. “If only the regulation had been stronger….” o As noted previously, this is an incorrect starting point. Regulation in the United States hasn’t been weak, it simply hasn’t been applied.• But what about “Systemic Risk” and “Resolution y Authority”? o The President’s Working Group (PWG), or any other number of forums, could’ve easily been leveraged as the equivalent of the FSOC y g q o Establishing “living wills” is a critical step for the TBTF/TCTM firms, as is the effort to harmonize these resolution cross-border. o OPINION: Ultimately, we will need to “show” the market RA is ‘red in tooth and claw’ b collapsing a TBTF/TCTM and hi i the credit stack, not j d l ’ by ll i d hitting h di k just equity.
  20. 20. DFA: It passes the “size” test• DFA is only ~385,361 words• However, the policy multiplier is ~10x  ~3 853 610 words of policy ~3,853,610 d f li• How many words in the Bible?  774,746, or a 4.97x factor  Gettysburg address 269 words (14,325x)  Declaration of Independence is p 1,337 words (2,882x)• IRS code?  ~5,500,000, or ~70% 5,500,000, 70%• Moral: We should be very busy Good summary of implementation timelines
  21. 21. Estimated Rulemaking by Agency* Chart produced by DavidPolk in its July 9, 2010 Summary of the DFA
  23. 23. Financial Stability Oversight Council Fi i l St bilit O i ht C il Subtitle A of Title I• The FSOC is established to oversee large, complex financial organizations (bank and non-bank)• Stress-testing:  Banks and non-banks deemed systemically important are expected to p p perform internal enterprise-wide stress-test semi- p annually (over than $10 billion – a low threshold – annually)• Impact: Over-emphasis is possible. FRB, Basel, FDIC, OFR, FSA OFR FSA, and other approaches toward stress-testing  See: 1) Supervisory Capital Assessment Program (SCAP), 2) BCBS 155 – “Principles for Sound Stress Testing Practices and Supervision”, 3) CP32 – CEBS – “Guidelines on Stress Testing”, 4) etc  Is anyone trying and harmonize across borders? Much of the TBTF/TCTM should be the product of a more universal set of enterprise-stress packages. Disclosure should be a key element.
  24. 24. The Powers of the FSOC• Arguably the centerpiece of the DFA (• Has the power to define systemically important entities, bank or non-bank• Has the ability to subject such firms to regulation o Credit, Capital Liquidity Concentration Disclosures Stress Credit Capital, Liquidity, Concentration, Disclosures, Stress- testing, and other required risk management protocols• To date: • Have held two well rehearsed public meetings (October 1, November 23rd) • Notably, and startlingly, virtual silence after Barr’s preliminary findings from the Foreclosure Task Force – “…inexcusable breakdowns in basic controls…” and these issues are “…widespread…”
  25. 25. Subtitle B: Office of Financial Research• Can and should be one of the most important elements of Title I• Began as S.3005: CE-NIF ( o Idea is to harmonize data standards “Bank information systems are not designed to aggregate information in this way on a regular basis. Much improvement is needed in these systems…but until strides are made, comprehensive stress-testing will remain very difficult.””…the issues I’ve just mentioned make me reluctant to difficult the I ve begin conducting such tests routinely as the cornerstone of our supervision.” (also emphasized that PFRs shouldn’t disclose the results) – Former Comptroller John Dugan, April 15, 2010, Richmond FRB o Idea, one of many, is to analyze and assess cross-entity risks
  26. 26. OFR: The Dream v. the Reality• Federal Reserve announces its own Office of Financial Stability Policy and Research on November 4th o How will these interact? o What are the intentions of the FRB with regard to OFR?• OFR could be viewed as a needed “fixer” and “motivator” of the technology infrastructure improvements that are desperately needed in SIFIs• Requires vigilance and participation by industry risk managers and IT professionals, esp when you hear sentiment such as: “The OFR must not duplicate existing government data collection efforts or impose unnecessary burden.” p y …and see meetings with the FRB like the recent Financial Services Roundtable, November 15, 2010 (
  27. 27. Living Wills: Orderly Liquidation Authority• Warning: When you hear - “The Taxpayer will never….”• Cross-border resolution of SIFIs was a missing element in the recent crisis o 13(3) powers of the FRB have been curtailed under DFA “…unusual and exigent circumstances…” clause of FRA §13• FDIC, in collaboration with the other PFRs, is moving to create realistic Resolution Plans• Numerous studies are required relative to operation of OLA v. BK, international issues, and other matters.
  28. 28. Other Areas of Impact• Enterprise Risk Management  Expect a greater emphasis on enterprise risk management, a deeper analysis of processes, need for adherence to established best-practice, best practice, and Board level risk-committee structure(s) [culture not compliance]• Executive and Incentive Compensation  Expect your risk management group to be part of these discussions “Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial risk taking instability.” – Chairman Ben Bernanke, October 2009• Consumer Protection Rules• Liquidity and Capital
  29. 29. What is missing from DFA?• Doesn’t deal with the fundamental problems that created the crisis.  Apologies to those that don’t like the term “malinvestment”. I find that the shoe fits fits.• FSOC. What is a bubble? How can you tell?  What if the greatest source of Systemic risk is the sovereign or one of its appendages? ( pp g (and that’s the easy problem) yp )• CFPB. Just wondering what happened to caveat emptor.  Off to a wobbly start. Wondering about warning labels.• TBTF. Need to see how OLA works in practice. p• OFR and the OFSP&R  A lot of potential, potentially.• Compensation. Compensation Title IX is a good stretch. Believe corporate stretch governance should have as much attention as risk management.
  30. 30. Agenda• Now about that regulatory failure…• Some words on the Dodd-Frank Act (DFA)• The future of finance and, importantly, financial risk management?
  31. 31. Impact of reform on risk management • Risk Management Impact? • F ll employment at: Full l t t  Deloitte, KPMG, PwC, BAH, Promontory  Have regulatory experience, experience will hire • Major areas of need:  Infrastructure issues  ERM is “for keeps”  Massive need for education
  32. 32. PRMIA areas of influence Holding to the Highest Standards in Institutional Risk Management Globally. Network. Understand. Act. 19 28 18Chapters Chapters Chapters
  33. 33. Collaboration and Situational Awareness is Critical• Our success throughout the reform process will be a function of effective collaboration. – paraphrase of Neal Wolin• “…global policy cooperation is fracturing at best ” global best. - John Lipsky, IMF• Markets remain fragile and it’s imperative we avoid it s sliding into financial protectionism
  34. 34. Many Opportunities for Improvement• CRO Attestation to Internal Risk Management Practices• Developing a Uniform Set of Risk Management Standards  Principles, not rules• Continued development of “specialists of the whole”  “On a Global Foresight Commons”, Carol Dumaine, 23 Nov 2010 On Commons , 23-Nov-2010  Unwinding Orthodoxy, the Value of Heresy, learning to “…profoundly challenge the status quo.”• The US is only “now” joining the International Association of y j g Insurance Supervisors (see FIO)• Expert needs around stress-testing  Subjectivity, Subjectivity Risk Imagination, and Expert-Based Systems Imagination  SME Swarming, Risk Mash-ups, Network Sensors, COEs (industry, regulatory, intelligence industry, other?)
  35. 35. Areas of Current Risk Focus• The search for earning assets  Beware the rise of Interest Rate Risk• Balance sheet management  New volumes – credit spread, risk and duration  Funding and deposit strategies (preparations made?)  Capital planning, including focus on non-organic growth (M&A should pick up)  Balance b B l between li idi and need f spread liquidity d d for d• Profitability, margin-protection, and efficiency• Financial risk and corporate governance• Regulatory preparedness
  36. 36. The Financial Crisis: Impacts on Risk Management and Key Lessons Learned Presented by: Thomas Day THANK YOU! Contact at: